Friday, 21 November 2008

Scarcity explains the financial crisis

Gail the Actuary has a spot on summary of the link between resource scarcity and the financial crisis.

Excerpt from An Overlooked Detail - Finite Resources Explain the Financial Crisis:
Now that we are reaching a point where the extraction of fossil fuels and minerals of all types are starting to reach limits, we find that if the economy starts to heat up, the price of many commodities starts to skyrocket. Part of this is competition for limited resources. Part of this is the high cost of extraction of these resources, now that we are increasingly reaching limits. Food prices are affected as well, partly because oil (for machinery) and natural gas (for nitrogen fertilizer) are used in food production, and partly because competition with corn production for ethanol drives land prices up.

Once food and fuel prices rise, people find it difficult to repay debt, and debt defaults rise. Now debt defaults are rippling through the economy. The poor financial condition of banks makes them unwilling to lend. This lack of credit is making it difficult for many direct and indirect buyers of commodities to buy products of many types (oil, natural gas, uranium, and copper, for example). Prices are plummeting for a wide range of products because prices are relatively inelastic. 

These lower prices have a feedback effect on new production of commodities. In a paper to be published in Journal of Energy Security shortly, I show that the credit crisis and the resulting lower commodity prices are leading to cut backs in planned production of energy products of all types (fossil fuels, renewables, and uranium). As a result, if the economy does start to heat back up again, we will have another round of commodity price increases. This, of course, will be followed by another round of debt defaults.